July 2012

In Sharyland Water Supply Corp. v. City of Alton, the Texas Supreme Court criticized an overbroad application of the “economic loss rule” (“the Rule”) but declined to precisely demarcate the Rule’s proper reach. Construction litigants in Texas will continue to struggle with how the Rule may provide a defense to tort claims arising out of construction contracts.

The Rule is readily applied to preclude tort claims in two contexts. The first is when a defective product causes damage to the product itself but causes no personal injury or damage to other property. In that context, the Rule limits remedies to those provided by contract or under the UCC. The second is when the plaintiff and defendant are in privity of contract and the only harm is to the subject matter of the contract. In that context, the Rule prevents breach of contract claims from being recast into tort claims.

The Rule is more difficult to apply when the plaintiff and defendant have no contract and the plaintiff suffers only economic loss rather than personal injury or property damage. “Economic losses” are generally those stemming from inadequate value, costs of repair and replacement of a defective product, or consequent loss of profits, without any claim of personal injury or damage to other property. Some courts hold that purely economic losses are not recoverable in a negligence action. And some courts hold that the Rule bars a negligence claim between parties who are not in privity if the damage consists of economic loss to the subject matter of a contract between the defendant and another party.

Sharyland owned a potable water system serving Alton, Texas. The City contracted with architects, engineers, and a contractor (“the Contractors”) to build a sewer system. Some of the sewer lines were located where Sharyland alleged they threatened to contaminate its water lines. Sharyland sued the Contractors for negligence. Its damages consisted of increased operating costs to encase its water lines and for other safety and maintenance precautions. A jury found the Contractors negligent and awarded Sharyland $14,000 in past damages and $1,125,000 in future damages.

The Corpus Christi Court of Appeals reversed. It determined that Sharyland suffered no property damage because none of its lines was physically harmed. The court then held that “In tort cases where there is an absence of privity of contract…economic damages are not recoverable unless they are accompanied by actual physical injury or property damage.”

The Texas Supreme Court reversed, holding that the court of appeals “both overstates and oversimplifies the economic loss rule.”

First, it noted that many torts allow recovery of economic losses absent physical injury or property damage. They include negligent misrepresentation, breach of fiduciary duty, and tortious interference with contract.

Second, it rejected the notion that because the sewer system was the subject of a contract (between the City and the Contractors), then Sharyland was barred from suing the Contractors for breach of an independent duty where the loss caused was “unrelated” to the contract.

But the court sidestepped the largest question on the scope of the Rule: “whether purely economic losses may ever be recovered in negligence or strict liability cases.” The court did so because it held that Sharyland in fact suffered property damage: it was obligated to relocate or encase its water lines, and its cost to do so “necessarily implies that the system was damaged.” This determination appears to be a stretch. There was no evidence that Sharyland’s lines were damaged. Its costs of “repair” were actually increased operating and maintenance costs to avoid future harm, rather than costs to fix already-inflicted harm.

By sidestepping, the court missed an opportunity to state specifically whether purely economic losses can be recovered in negligence or product liability cases. Arguably, without the protection of the Rule, parties face uncertain potential liability for purely economic losses allegedly suffered by strangers. In Sharyland Water, the Contractors performed their Contract with the City, but were found liable to Sharyland for damages measured by Sharyland’s operating and maintenance costs, rather than costs of repairing actual damage to property resulting from the Contractors’ work.

This issue will arise again in another case, without a doubt. In the meantime, parties to construction contracts may wish to look around the jobsite a bit more carefully.